By creating conditions that could lead the Federal Reserve to slow the recovery, President Biden’s $1.9 trillion economic relief and stimulus proposal might stop the benefits of an expanding economy from reaching low-wage workers.
According to my calculations, economic output will be around $335 billion below its underlying potential for the final 10 months of 2021. Under the conservative assumption that every dollar of stimulus would generate 50 cents of economic activity, the president’s proposal would fill the output gap nearly 3 times.
This would add to the considerable demand-side inflationary pressures already facing the economy this year. Those include households sitting on $1.6 trillion of excess savings and the $900 billion stimulus Congress passed just two months ago that has yet to be fully spent. More people are vaccinated every week, and as the virus fades this summer households may go on spending sprees. Pandemic-related supply chain disruptions and the need for the economy to reallocate labor and capital to the post-virus “new normal” will inhibit the ability of supply to keep pace with demand. There will be considerable upward pressure on prices.
All this likely will be occurring against the backdrop of a robustly growing economy and a falling unemployment rate.
There is significant uncertainty about the response of consumer price inflation to these factors. Economists do not adequately understand how inflationary pressures affect expectations about inflation, or how expectations about prices and actual prices affect each other. It may be that the economy can absorb this degree of fiscal stimulus and proceed through the end of the pandemic without large increases in prices. The future paths of GDP, employment, and the output gap are all unusually uncertain, as well.
But there is a real possibility that inflationary pressures will lead to actual inflation. Much of the debate has focused on the possibility of the U.S. entering a new, sustained inflationary regime. This would obviously be problematic. But more benign scenarios could be problematic, as well.
Trend inflation rising, say, 50 basis points above the Fed’s 2 percent target would be a welcome policy victory. But inflation would become front-page news if that trend were coupled with a month here and a month there of 4 or 5 percent price growth. It would be the talk of market participants. Congress might hold hearings.
In addition, the big boost in income from the president’s stimulus plan would balloon households savings above its already elevated levels. This will cause asset prices to continue to rise. The Fed would become increasingly concerned that excessive demand was fueling financial market bubbles.
In the face of this dynamic — trend inflation above target, occasional spikes in monthly inflation data, and concern about financial market bubbles — the Fed could quickly begin to feel that it had fallen behind the curve.
In this situation, the Fed might try to slow the pace of the expansion without ending it. But confidence in the Fed’s ability to fine tune the economy is misplaced. When the unemployment rate goes up a little, it tends to go up a lot.
Prematurely ending or slowing the post-virus expansion would create the risk that low-wage workers would be left out of the recovery. The U.S. experience in the economic expansion following the 2008 financial crisis and Great Recession makes clear that a rising tide does lift all boats — but that that process takes some time. This highlights the importance of keeping the post-virus expansion going as long as possible.
In a new paper with economist Jay C. Shambaugh, I study the economic expansion that officially began in the summer of 2009 and ended in March 2020, when the pandemic and lockdowns began. During this period, inflation-adjusted wages on average and at the top (the 90th percentile) were always above their level in 2007, when the Great Recession began.
Following the Great Recession, the economy began growing in 2009. Had that expansion ended in 2014, real wages at the median and 20th percentile would have fallen below their 2007 levels.
From my new paper with @JayCShambaugh.
— Michael R. Strain (@MichaelRStrain) February 16, 2021
Contrast that to wages at the middle and the bottom. Wages at the bottom (the 20th percentile) fell until 2014, and median wages fell until 2012. The median wage didn’t return to its 2007 level until around 2014, and it took the 20th percentile wage a year longer to recover from the financial crisis.
The upshot is that if the expansion from the Great Recession had lasted five years, ending in 2014, then the bottom half of workers would have seen their wages fall during the recovery. They would have been worse off when the recovery ended than when the Great Recession began.
Fortunately, the recovery from the Great Recession was the longest expansion in U.S. history. By 2019, real wages were up relative to 2007 by around 15 percent on average, 13 percent at the 20th percentile, and 7 percent at the median.
For the sake of the bottom half of workers, our goal should be for the expansion following the Pandemic Recession to beat that record. An expanding economy is the best jobs program we have.
If the president’s $1.9 trillion proposal were better targeted on low-wage workers and low-income households, then the risk of overheating and prematurely ending the current expansion might be justified. But it isn’t, with large sums of money intended for the middle class.
Overheating is not a certainty. It is a risk. But it could lead to truncating the length of the expansion — and excluding lower-wage workers from its full benefits. That risk is not worth taking.